Real options: Taking stock and looking ahead Yong Li, Barclay James, Ravi Madhavan and Joseph Mahoney Advances in Strategic Management (2007) Presented by Daniela Pedraza Novak

Real Options Theory Theoretical explanation for why firms may make investment decisions that differ from what the net present value (NPV) approach would prescribe Growth, abandonment and switching options Real Options Rights but not obligations to take some action in the future Create economic value by generating future decision rights Confer managers flexibility when facing uncertainty Useful in the absence of sufficient information

Taking Stock: Applications of Real Options Theory Option to Wait-to-Invest Options to Abandon and Switch Growth Options Interaction of Options

Option to Wait-to-Invest Provides strategic flexibility to defer the investment until additional information is received with the passage of time Option is more valuable with high exogenous uncertainty Option to Abandon and Switch “Put Option” Gives firms the right to abandon an investment if market conditions get worse or switch when conditions are adverse Value increases with the salvage value and future uncertainty

Interaction of Options Growth Option “Call Option” Allows firms to make additional subsequent investments Multi-stage projects 1st stage: create --- 2nd stage: exercise Interaction of Options “Project value” The incremental value of each additional option is usually not equal to its economic value in isolation Value is attenuated by “substitute” but enhanced by “complementary” options

Extension of Real Options Theory of Investment Portfolio of Options Firm decisions as bundles of real options R&D as “creating real options” Competition and investment Competition complicates investment decisions Anticipation of rivals’ investment matters Endogenous uncertainty and learning Reduced through strategic investments May encourage firms to invest Cost uncertainty  Technical (+) & Input cost (-) Exit decisions and hysteresis Delaying exit may be rational under uncertainty and irreversibility Valuable when restarting costs are high (Sunk costs)

Organization and Governance How should firms invest and organize activities? Preferred investment modes under uncertainty: Joint Venture (collaboration) > acquisition or internal development Market-like mechanism > integration In collaborative ventures Option value of acquiring or selling the venture depends on: Divergent economic valuations of the venture ex ante Divergence of ex post valuations

Valuation and Performance Implications Real options theory is fundamentally a theory of economic valuation Takes the value of managerial flexibility into account Economic value of a firm derives from assets in place + growth options Performance implications Technological competence (holding patents) in uncertainty  higher market value IJVs have positive impacts on growth option values Multinationals have greater flexibility in shifting value chains, compared to domestic-only firms

Looking Ahead: The Future of Real Options

Areas of future research Real Options, Learning and Heterogeneity Different investment patterns Real Options and Game Theory Integration Real options are usually shared, and their economic value may be eroded by competition Real Option Theory on Exit/Abandonment Decisions Inaction (exit delay) Uncertainty and irreversibility Organizational Portfolio of Projects and Businesses Firms often manage a portfolio of projects simultaneously or sequentially Effects of Uncertainty Ambiguity in the sources of uncertainty

Areas of future research Options Theory as a complementary approach to Transaction Cost Theory Contractual issues for uncertain investments Costs of creating and exercising options Flexibility Too costly to obtain Venture Capital and Entrepreneurship Clarify mixed empirical results

Issues in Implementation and Questions Finding an options pricing model whose assumptions match those of the project being analyzed Determining the proper measures for the variables Solving it mathematically Promising questions Who controls the decision rights to the option? What changes in the firm’s processes are needed to manage real options? What changes in the organization are needed to capture the option value?